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Rising Interest Rates Could Hurt These Stocks The Most

David Sterman

Are you looking to buy a new car? Don't pay cash

A 48-month loan for a new car is currently just 2.58%, according to Bankrate.com. That's below the historical rate of inflation (going back over the past half century). By the time your loan is paid off in four years, the inflation rate could exceed that 2.58% rate, meaning your real borrowing costs would actually be less than zero percent.

But don't wait too long. Interest rates have begun to rebound and are expected to rise gradually higher over the next few years. That auto loan rate will likely be closer to 5% in a few years. 

In fact, this issue is probably being discussed in boardrooms at the top auto companies and just about any firm that relies on low-cost loans to spur demand. Corporate executives realize that consumer confidence and spending trends remain challenged, even with the aid of low interest rates. How will these credit-dependent businesses fare when rates rise?

The Long And The Short Of It
It's crucial to distinguish between interest rates set by the Federal Reserve and interest rates affected by economic forces. The Fed controls so-called short rates, which, as I noted last month, are likely to stay low for several years to come.

In contrast, bonds of longer duration (such as the 10-year Treasury bond) have their value determined by bond traders, who tend to pursue higher rates whenever they see a strengthening economy. After all, economic expansion always threatens to introduce inflationary pressures, and interest rates need to reflect that possibility.

Who Feels The Pain?
In addition to automakers, several other industries are affected by rising rates. The list starts with homebuilders. 

For much of the past year, a 30-year mortgage could be had for 3.35% to 3.65%. But recently, the rate suddenly moved above 4%, and economists are warning consumers to brace for 5.5% mortgages within a year or two -- as long as the U.S. economy strengthens in 2014. (The International Monetary Fund (IMF) predicts the U.S. economy will grow 1.7% this year and 2.7% in 2014.)

What's the difference between a mortgage rate of 3.5% and a 5.5% rate? A lot. If you buy a $300,000 home, put 20% down and finance the other $240,000, your monthly payment would jump nearly 27%, to $1,363. For people who barely qualified at that lower monthly payment, the higher rate would price them out of that home purchase.

This is all worth pondering if you are thinking about investing in homebuilders. These firms appear poised for solid demand down the road whenever the economy becomes truly healthy. But in the near term, rising mortgage rates may lead to a slowdown in demand, which as this chart indicates, few are anticipating right now.

The Housing Corollaries
Beyond the homebuilders, a number of firms have benefited from rampant levels of home-price speculation, as buyers snap up cheap homes, spruce them up and hope to flip them for a quick profit

For example, these speculators often put in new flooring to give their homes a fresher look, which has been a boon for Lumber Liquidators Holdings (LL). This stock has risen nearly 500% since the start of 2012 and now trades for more than 40 times trailing earnings. But what happens if rates rise and speculation activity slows? This isn't a stock I'd want to be holding.

And tread lightly with the "white goods" appliance makers that stimulate demand with cheap financing. 

For example, Whirlpool (WHR) has seen its shares double in the past year as consumers tap low-cost credit lines for home improvements. How long can that trend last as financing costs move higher?

The Corporate Angle
It's worthwhile to examine any consumer-facing stocks that you own to see how much of their sales are dependent on financing. And it's also wise to look at other types of companies to see how their debt is structured. 

Many companies have wisely locked in long-term debt at fixed rates. But many other companies are heavily dependent on credit lines and other forms of revolving debt that are tied to the LIBOR, the London Interbank Overnight Rate. Borrowing with LIBOR in recent years has been advantageous, but an increase in this benchmark interest rate may be inevitable as the global economy starts to mend. 

Risks to Consider: As an upside risk to interest rates, it's unclear if the economy will continue to strengthen. If the economy remains weak, then interest rates will likely remain near multigenerational lows.

Action to Take --> Remember that "investors think ahead," and though any interest rate increases are likely to be gradual, investor anticipation of such a move could happen more rapidly. So you shouldn't wait until mortgage rates and other interest-sensitive financial instruments have already made their move.

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